Oil's Fledgling Recovery: Should Investors Jump In?

Amid growing confidence about an economic recovery by the end of the year, the energy sector seems to be off to the races again. One nagging question persists: Will it last?

The May oil contract on the New York Mercantile Exchange settled at $54.34 on Mar. 26, up 13% since Mar. 16. The Amex Oil Index, which contains 12 oil-oriented stocks, closed at 910.68 on Mar. 26, up nearly 9% from 836.60 on Mar. 16, the day before the price of oil settled above $50 for the first time since Jan. 26. The index is still well below its closing price of 1,019.80 on Jan. 2.

Much of the rally in oil prices and energy stocks over the past week or two may simply reflect a more positive tone in the broader market as investors become more confident that the Obama Administration is getting a handle on how to resolve the toxic assets issue.

Weaker U.S. Dollar a Factor

Given how bearish market sentiment in the energy sector has been over the past six months, many fund managers and other investment pros have decided that the risk of a rapid run-up has increased, and it's time to at least exit their short positions and return to a neutral energy weighting, according to Clay Hoes, who is a sub-adviser for the $50 million AmEx Global Equities Energy Fund.

While fund managers and analysts recognize that a weaker U.S. dollar and resurgent fears about inflation due to ballooning government debt have contributed to the oil rally, many believe it's based more on anticipation of economic recovery by the end of 2009. "Energy is looking for an uptick in global gross domestic product," says Hoes. That's the central aim of all the money that the U.S. and foreign governments have pumped into the system, he adds.

There's always the chance that gloom will resurface and oil prices will resume their downward spiral, but analysts say they're reassured by a high level of compliance with a recent 4.2 million barrel-a-day cut in the OPEC's production quotas. Cartel members are 80% to 90% compliant with the cuts this time, compared with 60% to 75% compliance in the past, says Tom Nelson, an analyst for the Guinness Atkinson Global Energy Fund (GAGEX), which manages $30 million in assets.

Confidence in OPEC

"That suggests to us that not only does OPEC have the firepower to support this oil price but there's enough internal agreement between OPEC members that they can actually achieve it," he says. That means the oil market may have put in a bottom and that prices will range between $50 and $70 a barrel from now on, he adds.

Another reason to believe that $45 to $50 could be a floor for oil prices is that the International Energy Agency has already abandoned any optimism it had about non-OPEC supply growth this year. The Paris agency said it now expects production from those countries to be unchanged from 2008. Nelson thinks non-OPEC production could end up lower than last year.

Still, with U.S. crude inventories at 16-year highs—they rose by 3.1 million barrels to 356.6 million barrels during the week ending Mar. 20, according to the latest data from the Energy Information Administration—it's just as easy to argue that fundamentals are not the primary impetus for the hike in oil prices. "We still haven't seen an uptick in demand. The EIA predicts oil usage will be down 4% in the second quarter of 2009 from [a year ago]," says Mike Zarembski, senior commodities analyst at OptionsXpress (OXPS) in Chicago.

Timing is Everything

Based on its optimism about market fundamentals, the managers at Guinness are looking toward stocks with greater exposure to the commodity. Nelson prefers independent exploration and production, or E&P, companies to the integrated producers whose refining and marketing businesses tend to put those companies in a more defensive position, and hamper their ability to profit from any upside in commodity prices.

The trick for investing in with E&Ps, however, is getting the timing of entry right. "You don't want to go too early," in view of the the challenge that depressed natural gas prices pose for the E&P companies, says Nelson. Where oil prices are generally expected to stay above $50, natural gas prices will probably decline further before bouncing back later this year or in early 2010. Expecting gas prices to drop to $4 per million British thermal units (BTU) in the second and third quarters, Roger Read, senior energy analyst at Natixis Bleichroeder , said in a Mar. 25 report that he had cut his 2009 price outlook to $4.50 from $6.25 per million BTU.

Most E&P firms' production is weighted more heavily to natural gas than to oil, but it's possible to find some that have a relatively small gas exposure. Nelson likes Occidental Petroleum (OXY), 75% of whose production is oil and the 25% gas, as well as Apache (APA), with 55% oil and 45% gas, and Noble Energy (NBL), with 40% oil and 60% gas. He likes the oil acreage that Noble owns in West Africa and its natural gas assets in Israel, which help to satisfy a portion of Israel's daily consumption needs.

Pricing Power Shifts To Exploration Outfits

Besides boasting solid track records for finding new resources and increasing production, these companies have other draws: well-capitalized balance sheets with very small debt-to-equity ratios — 4% for Occcidental, 17% for Noble and 18% for Apache, says Nelson.

Overcapacity in the oilfield services sector as a result of a plunge in the U.S. land rig count to 800 from 1,600 rigs six months ago means the pricing power is now in the hands of the exploration companies, says Nelson at Guinness. "They're in a position to squeeze these guys on equipment, rig [rental] rates, crews and technical support," he says.

Brian Youngberg, an analyst at Edward Jones in St. Louis, agrees that integrated oil producers are less directly exposed to rising energy prices than E&Ps but still recommends clients base their energy exposure on integrated companies before branching out to stocks focused on one part of the industry.

BP's Dividend Looks Safe

He likes Chevron (CVX), the most oil-based of the major integrated players, and BP (BP), which is paying an attractive dividend even as it's been restructuring its refining operations for the past few years. Youngberg thinks BP's dividend, which is yielding 8%, is safe for the rest of 2009 and would be at risk only if oil returns to $40 in 2010. BP's efforts to improve its refinery operations and bring them up to the level of its peers will help drive higher earnings in the future, he predicts.

One of his favorite E&P picks is Energen (EGN), a smaller producer weighted mostly to natural gas, which "has a great track record, conservative management," and is "well-positioned to make nice acquisitions this year" with cash it has saved.

Natural Gas Demand Could Explode

AmEx Global Equities' Hoes thinks the E&Ps are in the process of bottoming. If the economy recovers in the second half of 2009, demand for natural gas is likely to exceed supply, which will drive up gas prices. He expects the E&Ps to start outperform forecasts before the rebound in anticipation of it.

For the longer term, his top choice is Petrobras (PBR), which he says has the best exploration profile of all the large integrated producers and can for now take advantage of cheaper drilling costs for offshore projects.

Analysts think independent refiners such as Valero (VLO) and Tesoro (TSO) are not good bets with oil prices rising, since their profit margins will be pressured. Credit Suisse (CS) cut its average earnings estimates for that sector on Mar. 23 by 14% for the second quarter and 13% for the full year, warning clients to expect a tough summer.

CapEx Programs Have Been Cut

The size of capital expenditure cutbacks in recent months, with producers delaying or canceling projects, ensures that oil supply will struggle to keep up with demand in the future. That's "a recipe for prices keeping up down the road," says Youngberg at Edward Jones, who sees $75 to $85 as a reasonable long-term price assumption.

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